BARON LAUDERMILK - 08 NOVEMBER 2011 Ten years ago, when people thought of free market capitalism, they imagined the United States’ robust and seemingly unstoppable economy. For the most part, they were right. The U.S. had an efficient and productive private sector, establishing billion dollar companies all over the world in a laissez-faire political environment, with little industrial, political or financial regulations.

People around the world believed that the American economy was an example for the world. It strategically survived the Great Depression and came out with a victory in World War II. It saw an economic boom under both Ronald Reagan and the fall of the Communist block and the Soviet Union in the late 1980s and early 1990s, which was thought to bring about “the end of history,” Francis Fukuyama, one of the world’s most respected political scientists, argued. The United States’ specific style of democracy and capitalism did seem to be the best example for countries to look up to.

But the world’s economic downturn in 2008 demonstrated that the U.S. system had major economic and political cleavages. While the United States was juggling high unemployment and soaring deficits and the European Union was struggling to keep the euro alive, China proved to the world that its state-run capitalism was an effective and highly productive system. China went virtually untouched during the 2008 economic crisis and came out of it as the world’s second largest economy. Western nations are still shocked as to how a country that did not have a functioning economy just fifty years ago was able to become one of the richest states in the world.

China’s method of achieving unprecedented economic progress in the last few decades is no secret. The Chinese government has carefully, deliberately, and strategically guided and manipulated its private sector to become loyal participants of the Communist Party’s game. The Middle Kingdom’s capitalism is a constant game of tug and war between the Communist Party and China’s private sector. This game has resulted in a stalemate, in which both sides are not able to pull the other side into the middle. The Communist Party wants to ensure its power over the state, but the private sector is constantly pulling for its own interests.

While the government’s bureaucrats have been getting their hands on many resources, and while the bosses in the private sector have made their fortunes, the inequality amongst the people is rising. The Gini Coefficient, a standard measure of income inequality in a society, is over 0.5, which is similar to many unstable, heavily corrupt nations in sub-Saharan Africa. The nation’s nearly 10 percent annual growth in GDP has pulled a half billion people out of dire poverty, but compared to the wealthy class in China, which consist of bureaucrats and executives, the average households is on a tight budget. The government has kept interest rates on savings accounts so low that they cannot keep up with China’s rising inflation. This system, which is in place to benefit state-run banks and their rent-seekers, has moved the wealth from the average Chinese person to state-operated banks, which are directly connected to affluent corporations and government-supported organizations. The stalemate in this game of tug of war between the Communist Party and the private sectors’ executives have made them strong and rich, but the people have not seen these benefits yet. There are only two players in this game of tug of war. The people are barred from this match.

The constant fight of power between the Communist Party and the private sector has resulted in a unique form of capitalism that I call “The Middle Kingdom’s capitalism”. This new Chinese style of capitalism has three classes. The most powerful class is the Communist Party. This class consists of any government worker who has been brought into its club. This brings protections, benefits, and networking opportunities to their close family members. The children of the Communist Party members, infamously known as “princelings,” are born with a silver spoon and they die with a silver spoon. They are guaranteed a cushioned life and access to high-paying jobs. The princelings are almost able to get away with murder, and their connections with the government allow them to bypass the weak, paid-off legal system.

After the Communist Party officials, the government executives and their families come in a close second. They are close to Communist officials, especially if they are working in industries that the government is interested in, such as commodities, information, and technology. The third class is everybody else; the students, farmers, city dwellers, etc. If an ambitious Chinese student wants to be successful, he or she must find a way to get into the first two groups.

The Middle Kingdom’s style of capitalism has compelled executives across the globe to pack up their businesses and move straight to the heart of China. U.S. companies have a particular interest in China. China is not just attracting U.S. companies because of China’s cheap labor and low taxes, but because the Chinese government is more receptive to capitalism than the U.S. David Rubenstein, the co-founder and managing director of the Carlyle Group, a massive equity firm, told Thomas Reuters that he thinks China’s new style of capitalism is more open to business ideas than Washington’s. In his words, “I would say that today when I go to China, I find more people in government who are interested in learning about the things that private equity can do to help an economy and help companies than you often do in Washington… Washington, for a number of reasons, is not as focused on the joys of private equity… So very often, you have to defend yourself when you’re talking to a member of Congress.”

The Middle Kingdom’s style of capitalism consists of the state owning all the major firms, but it allows smaller firms to work without much regulation and interference. The Chinese government may want to maintain its power over its massive state-owned companies, but it should realize that the smaller, private companies are more profitable and effective. According to a paper by Liu and Alan Siu, unlisted private companies have an average return of around 10 percent a year. State-owned companies are earning a mere 4 percent a year. These private firms are rapidly growing. Between 2000 and 2009, registered private companies grew by 30 percent. Non-governmental industries are producing two-thirds of the country’s industrial output. Yet there is still fear that these businesses could be shut down on a whim.

Yes, the Middle Kingdom’s style of capitalism has produced a robust and booming economy. There does appear to be a healthy mixture of state-owned companies and private enterprises in China. There is no doubt that it would be foolish for an international company to not get involved in the Chinese market. Yet the fear that the Communist Party can just can suddenly shut down a company and choose favorites, and the fact that the legal system is fragile, strikes fear in all private and corporate businesses, foreign and domestic. Richard McGregor, the former Beijing bureau chief for the Financial Times, clearly said in his excellent book The Party that the Communist Party can fire, replace, and move executives of its state-owned international company spontaneously, with little to no notice. What kind of international company, or even a privately owned Chinese company, would put all their eggs in China’s basket?

This new form of capitalism will see its economy stagnate if the government does not allow freedom of speech and the press. All journalists, novelists, essayists, lawyers, and good politicians must be careful of what they write and say. The Communist Party has frequently demonstrated that it has no problem with incarcerating famous critics, as we have seen with Ai Weiweiand Lu Xiaobo. There are a variety of industries that are not able to grow because people are not able to think for themselves. The regulations on freedom of speech and press must be eradicated in order to allow the spread of ideas and business.

China’s new style of capitalism will slow down in the next decade because of the attempt of the government to transition the economy from one based on exports to one based on consumption. As Hugo Dixon argues in The China Files, Part 1: How fast can China grow?, “These trends can’t continue at the same pace. The country’s exports are now so big that it can’t keep expanding its share of world trade so fast. What’s more, its indebted customers in the West have a limited ability to keep buying.” The Chinese government rightly laid out in its last five-year plan (2011-2015) that it will boost domestic consumption and rely more on its services. But in order to do this, China must alter its education system, which is based around memorizing text and obeying authority instead of thinking for oneself, and back off of the economy and the nation’s politics.

The Middle Kingdom’s form of capitalism has pulled a half billion people out of poverty, made millions of people across the world rich, and will probably keep loaning to the United States and Europe. But at the same time, people should be skeptical of this mutation of capitalism. It is still an unpredictable system. This elite group will do what it takes to stay in power, as we have seen in both Mongolia and Tibet, a move which is bad for business. We must give the Chinese government credit, for they have proved that state-owned capitalism is possible, but now let’s see them peacefully make the transition to a more free and open society.